Wednesday, July 31, 2013

Yesterday the Securities and Exchange Commission (SEC) announced that West Clark Community Schools -- and Indiana School District -- City Securities Corporation and Randy G. Ruhl have been charged with defrauding investors in connection with municipal bond offerings. The SEC order against the school district can be found here (PDF) and against the underwriter here (PDF).

The action stems from the fact that the school district was contractually obligated to disclose financial information on an annual basis. This "continuing disclosure" requirement is outlined on page 24 of the West Clark First Mortgage Refunding Bonds, Series 2005, official statement (PDF).

The SEC alleges that the school district "had not submitted any of the required annual reports or notices for a 2005 bond offering" and as a result failed to conduct adequate due diligence in connection to detect the false statement contained within the West Clark First Mortgage Refunding Bonds, Series 2007, official statement (PDF). In particular, the 2007 offering contains the following false statement (page 30): "[i]n the previous five years, the [school district] has never failed to comply [...] with any previous undertakings in a written contract or agreement that is entered into". Since the school district did not file annual reports in connection to the 2005 offering, this statement is materially false.

The SEC has fined the underwriting firm $300,000 as well as almost $280,000 in disgorgement and prejudgment interest. Ruhl, without admitting or denying the commission's findings, has agreed to pay nearly $40,000 in connection with this action as well as a permanent supervisory bar. The school district has six months to ensure disclosures are current and accurate, implement personnel training, and establish procedures for the efficient submission of required documents to the MSRB.

Yesterday's action comes on the heels of the SEC's charges against the cities of South Miami, Florida and Victorville, California, which we discussed just a couple months ago. Some commentators also suggest that the SEC will have a role to play in the current Detroit bankrupcy proceedings (it would not be the first time the SEC has investigated Detroit municipal officials). Whether the additional scrutiny by the SEC will lead to a prolonged decrease in municipal securities fraud is an open question, but hopefully these actions at least locally bolster investor protection.

Tuesday, July 30, 2013

Lately, we've been fascinated by structured certificates of deposit (CDs), also known as 'market-linked CDs', 'equity-linked CDs', 'market contingent CDs', etc. Structured CDs are bank deposits that have interest payments linked to market indexes, individual stocks, commodities, or any other underlying asset. Unlike structured products, which have public SEC disclosure documents, structured CDs are not well studied and even the size of the market is not perfectly clear. We covered the basics of structured CDs in a concentrated week of coverage as well as a couple sporatic posts on the blog.

Today we have released a new working paper on structured CDs, available from the SLCG website (PDF) as well as SSRN. In it, we provide a glimpse into this obscure market by summarizing over 2,000 structured CDs issued over the past few years. We analyze four particular types that were common in our sample and value over 300 structured CDs issued by a variety of banks.

Our results were surprising. One might think that because structured CDs are FDIC insured, their reduced credit risk relative to structured products would make them more valuable to investors. However, we document mispricing of structured CDs from face value that is of similar magnitude to that seen in the structured products market. This suggests that in the aggregate, issuers are able to charge investors a similar level of gross margin in structured products and structured CDs.

Please check out the paper, and as always, let us know if you have any questions or comments.

Monday, July 29, 2013

The Wall Street Journal is reporting that JP Morgan plans to sell their physical commodities assets "amid heightened regulatory scrutiny of Wall Street's ownership of such assets."1 JP Morgan joins several other investment banks, including Goldman Sachs and Morgan Stanley, who are looking to sell or wind down their stakes in physical commodities.

According to the WSJ, the sale by JP Morgan will include trading desks that trade metals, power and fossil fuels. JP Morgan has drawn particular scrutiny for its role in the spot electricity market, which may lead to a record fine from the Federal Energy Regulatory Commission. Goldman Sachs has likewise been accused of anti-competitive behavior in restricting the supply of aluminum to benefit its trading positions.

The Federal Reserve has been handing out permission for banks to hold physical commodities on a case-by-case basis since the 1990s and just last week we reviewed the effects of this approval. JP Morgan began ramping up its commodities business in 2008, under intense competition from Goldman and Morgan Stanley.2

It will be interesting to see if the banks will sell their physical commodities assets before the regulators step up to force the banks out this decidedly non-bank business. It will also be interesting to see if hedge funds or other financial firms with more regulatory flexibility buy those assets.
_________________________________1 Late last year, we discussed how a JP Morgan physical copper ETF could be a big deal for the physical copper market.2 Although JP Morgan has become a key player in commodities, revenue from this business-line contributed just 1.4% of the company's revenue for the first half of 2013.

Friday, July 26, 2013

This week the SEC charged Richard Lee, a former portfolio manager at SAC Capital Advisors, with insider trading "ahead of public announcements about a Microsoft-Yahoo partnership and the acquisition of 3Com Corporation by Hewlett-Packard." Lee's alleged insider trading caused "the S.A.C. Capital hedge fund that he managed to generate more than $1.5 million in illegal profits." The SEC has charged Lee with violating sections of the Exchange act and seeks disgorgement, prejudgment interest, financial penalties, and permanent enjoinment from future violations of the securities laws. Criminal charges have also been announced against Lee.

Patrick J. Kiley was sentenced to "20 years in prison and ordered...to pay $155 million in restitution" based on his "conviction on 15 criminal counts including mail and wire fraud, conspiracy to commit mail and wire fraud, and money laundering for his role in a $194 million foreign currency trading scheme that defrauded approximately 1,000 investors." Additionally, Kiley is a defendant in a civil injunctive action filed by the SEC. This action "arose out of the same facts that are the subject of the criminal case against him." The SEC's complaint charges Kiley and co-defendants Trevor G. Cook, Jason Bo-Alan Beckman, and Beckman's investment advisory firm, Oxford Private Client Group, LLC, with violating various sections of the securities laws. A permanent injunction was entered against Cook in 2010 and a receiver was appointed to "to marshal and preserve all of the Defendants' assets." The cases against Kiley and Beckman remain pending.Massachusetts-Based Penny Stock Promoter Ordered to Pay Over $1.6 Million in Penny Stock Fraud Case, July 25, 2013, (Litigation Release No. 22759)

A final judgment was entered against National Financial Communications, Inc. for making "material misrepresentations and omissions in penny stock publications" it issued with Geoffrey J. Eiten. The judgment enjoins NFC from future violations of the securities laws and imposes a penny stock bar against NFC. Additionally, the judgment orders NFC to pay over $1.6 million in disgorgement, prejudgment interest, and civil penalties. The SEC's case against Eiten remains pending.

Former Investment Banker and His College Friend Sentenced to 16 Months in Prison for Insider Trading Scheme, July 25, 2013, (Litigation Release No. 22758)

Jauyo "Jason" Lee and his friend, Victor Chen, were sentenced to "16 months in prison for their roles in an insider trading scheme." The defendants were also sentenced to "two years of supervised release following their incarceration and ordered that restitution and forfeiture be considered at a subsequent hearing." Chen previously paid over $600,000 in forfeiture. The SEC's original complaint charged Lee and Chen with violating sections of the Exchange Act. The SEC's complaint seeks "disgorgement,...prejudgment interest, civil penalties, and permanent injunctions against Lee and Chen" and remains pending.

New York State Suspends Attorney Mitchell S. Drucker from Practicing Law for Three Years Based On Insider Trading Violation, July 25, 2013, (Litigation Release No. 22757)

A decision was issued by the Appellate Division, Second Department, of the New York State Supreme Court, that suspends "attorney Mitchell S. Drucker from the practicing law for three years." This decision is based on a judgment the SEC obtained in its "insider trading case against Drucker" (SEC v. Mitchell S. Drucker, et al). In 2007, a jury found that Drucker, a former member of the legal department of NBTY, Inc., had "violated the antifraud provisions of the securities laws by insider trading the common stock of NBTY, tipping his father, who traded, and trading his friend's NBTY shares." Drucker had previously been enjoined from violating sections of the Securities Act and Exchange Act and was barred from serving as an officer or director of any public company. He was also ordered to pay over $400,000 in disgorgement, prejudgment interest, and civil penalties.

Settled charges were filed against Jorge Bravo, Jr. for the "unlawful sales of millions of shares of" AVVAA World Health Care Products, Inc. "to the public without complying with the registration requirements of the Securities Act of 1933." Bravo consented to a final judgment that permanently enjoins him from future violations of the Securities Act, places a penny stock bar against him, and orders him to pay almost $600,000 in disgorgement, prejudgment interest, and penalties.

According to the complaint (PDF), China Intelligent Lighting and Electronics, Inc., NIVS IntelliMedia Technology Group, Inc., and their respective CEOs, Xuemei Li and, her brother, Tianfu Li, "engaged in fraudulent schemes to raise and divert offering proceeds." They then allegedly "attempted to hide the diversions by lying to auditors and making false and materially misleading filings with the Commission." The SEC seeks permanent injunctive relief, disgorgement with prejudgment interest, civil penalties, officer and director bars, and "any other appropriate relief." Additionally, the SEC entered an order "to determine whether the registration of each class of securities of CIL and NIV should be revoked for failure to make required periodic filings with the Commission."

A judgment was entered that approves "a $324,777 settlement between the Commission and Robert D. Ramnarine, a former executive at Bristol-Myers Squibb Co., in a case that arose from allegations of insider trading in the securities" of ZymoGenetics, Inc., Pharmasset, Inc. and Amylin Pharmaceuticals, Inc. The final judgment also permanently enjoins Ramnarine from future violations of the Exchange Act and Securities Act, places an officer and director bar against him, and " requires that funds in a brokerage account controlled by Ramnarine that were frozen by previous order of the Court be transferred to the Commission."

A parallel criminal case, U.S. v Ramnarine, was filed. Ramnarine pled guilty to securities fraud and is scheduled to be sentenced on September 26, 2013.

According to the complaint (PDF), the City of Miami and its former Budget Director, Michael Boudreaux, "made materially false and misleading statements and omissions concerning certain interfund transfers in three 2009 bond offerings totaling $153.5 million, as well as in the City's fiscal year 2007 and 2008 Comprehensive Annual Financial Reports." Allegedly, the City, through Boudreaux, "transferred a total of approximately $37.5 million from its Capital Improvement Fund and a Special Revenue Fund to the General Fund in 2007 and 2008 in order to mask increasing deficits in the General Fund." The transferred funds, however, included " legally restricted dollars which, under City Code, may not be commingled with any other funds or revenues of the City." Additionally, "the funds transferred were allocated to specific capital projects which still needed those funds as of the fiscal year end or, in some instances, already spent that money." These transfers allowed the City's bond offerings to receive favorable ratings by credit rating agencies. Once the majority of the transfers were reversed, "the City had to declare a state of fiscal urgency..., and bond rating agencies downgraded their ratings on the City's debt." The SEC has charged the defendants with violating various sections of the Securities Act and Exchange Act and seeks injunctive relief and financial penalties. Additionally, the SEC has charged the City with violating a 2003 "SEC Cease-and-Desist Order which was entered against the City based on similar misconduct" and seeks an order "commanding the City to comply with the SEC's 2003 Order."

Thursday, July 25, 2013

What monthly income will you need? Forbes claims this is the fundamental question that is often overlooked by 401(k) account holders.

“The lump sum in your 401(k) may seem like a lot, but when you translate it into a monthly income stream over 20 or 30 years, it may not be as much as you think,” [Jeanne Thompson of Fidelity] says. “Breaking it down into how much the money will provide will give you a much better picture of how much you’ll have to spend in retirement.”

Another important question is, how much of your savings will be consumed by fees? Vanguard founder John Bogle argues that fees have an enormous effect on 401(k) accounts, and that even small differences in fees can lead to drastically different retirement income.

One by one and year by year, the excess costs you pay for management, commissions, taxes and turnover can easily reduce your return by two percentage points...after a lifetime of modest investments, a return of 8% can leave you $2,755,274 to spend in retirement; but at 6%, those same investments can leave you with only $1,209,551.

Retirees also have to consider what returns are possible on their account, their current contribution level, the amount their employer matches, how long they plan to work, etc. Needless to say, the calculation gets confusing, especially since all of these different decisions affect each other in often unexpected ways.

To help illustrate the effect of each of these decisions, we have created an Excel spreadsheet that calculates monthly income (before taxes) at retirement given a variety of inputs such as current salary, contribution levels, account fees, etc. We also calculate the amount of fees paid both before and during retirement, and include the entire contribution and payout schedules over time.

Let's walk through the spreadsheet with a few examples. We'll assume that each example has a pre-retirement 401(k) allocation that returns 6% and a post-retirement allocation that returns 3.5%, each with a fee of 1.5% annually.

Suppose you're a 25 year old who plans to retire at age 65 (in 40 years). You contribute 6% of your $40,000 salary, your employer matches the first three percent and your salary grows at about 3% per year. Assuming you've saved about $5,000, at retirement you'll have about $665,975 paying approximately $124,739 in fees up to retirement. Let's say this retiree expects to live to age 80 and so needs 15 years of retirement income. The retiree will have about $4,287 of pre-tax income each month; however the purchasing power of the monthly income will likely be greatly diminished by inflation.1

Suppose you're a 55 year old who plans to work through 70 (in 15 years). You contribute 10% of your $60,000 salary, your employer matches the first five percent and your salary grows at about 4% per year. Assuming you've saved about $150,000, At retirement you'll have about $542,632 paying approximately $67,499 in fees up to retirement. Assuming this retiree expects to live to age 80 and so needs 10 years of retirement income. The retiree will have about $4,995 of pre-tax income each month.

Please feel free to download the spreadsheet and to try a variety of different parameters. You can change the cells with orange backgrounds to see the effects of each assumption. We think you'll agree -- when saving for retirement, there is a lot to consider!

__________________________________________________1 Assuming a 7% price inflation rate (conservative compared to the last 10 years), a tank of gas that costs $50 today will cost this retiree approximately $750 at retirement. Taking a 3% inflation rate for other purchases, a $100 grocery bill will come to about $326 at retirement.

Wednesday, July 24, 2013

Physical commodities -- barrels of oil, bars of gold, bushels of wheet, etc. -- are used for a variety of industrial purposes, but can also be bought and sold in financial markets. Most commodities trading involves futures contracts, as trading the physical commodity itself involves transportation and storage costs. Traditionally, banks who traded commodities were only allowed to deal in derivatives such as futures contracts, rather than dealing in the physical commodity itself.

But since the 1990s, several banks have been approved by the Federal Reserve to buy warehouses, pipelines, and other assets related to the storage or transportation of physical commodities. And according to a recent investigation by the New York Times, banks have used their control over physical commodities to increase prices and their own trading profits:

By controlling warehouses, pipelines and ports, banks gain valuable
market intelligence, investment analysts say. That, in turn, can give
them an edge when trading commodities. In the stock market, such an
arrangement might be seen as a conflict of interest — or even insider
trading. But in the commodities market, it is perfectly legal.

The example highlighted by the New York Times involved 27 aluminum warehouses in Detroit owned and operated by a subsidiary of the investment bank Goldman Sachs. Goldman allegedly moved aluminum ingots between these warehouses in order to delay shipments, effectively reducing world aluminum supply and thereby increasing prices. As banks' stockpiles of physical commodities have grown, their ability to control supply and demand (and therefore price) has increased.

These and other practices are now under intensescrutiny, and the Federal Reserve is reportedly reconsidering its relaxation of restrictions on banks. Interestingly, similar concerns have been raised about proposed exchange-traded funds (ETFs) that will own physical copper. In that case, if an ETF amassed a large stockpile of physical copper, then physical copper prices might increase (due to decreased supply), increasing the cost of industrial uses of the metal.

It will be interesting to see how regulators deal with banks' increasing presence in commodities markets, and how they might prevent anti-competitive behavior.

Monday, July 22, 2013

In January, FINRA released their annual regulatory and examinations priorities (PDF) for the upcoming year, in which they vowed to "focus significant resources" on, among other things, algorithmic trading and high-frequency trading (HFT) abuses. They have already levied a record fine against a brokerage firm for failing to supervise manipulative high-frequency trading, and their emphasis on HFT issues mirrors efforts by the SEC and CFTC to bring the HFT industry under better regulatory control.

Late last week, FINRA posted a Targeted Examination Letter highlighting many of the issues raised in the priorities document. According to Law360, the letter has been sent to about 10 firms. The letter requests details concerning HFT firms' software development including specific details about the supervision and oversight of modifications and testing under non-normal/extreme market conditions. FINRA also wants HFT firms to provide information on their controls to minimize market impact (such as manual or automatic "kill switches").

The SEC announced a proposed rule -- Regulation Systems Compliance and Integrity ("Reg SCI") -- earlier this year to "better insulate the markets from vulnerabilities posed by systems technology issues." The period for comments on was extended through July and has recently closed. We hope that the end result of Reg SCI and FINRA's examination will be more stable financial markets that are less prone to trading abuses.

The federal district court in Massachusetts "held that...Steven Palladino, and his...company, Viking Financial Group, Inc., committed securities fraud." According to the SEC, "since April 2011, Palladino and Viking falsely promised at least 33 investors that their money would be used to conduct the business of Viking - which was to make to short-term, high interest loans to those unable to obtain traditional financing." In reality, few real loans were made, and the defendants used investors' funds "largely to make payments to earlier investors and to pay for the Palladino family's substantial personal expenses." The SEC charged the defendants with violating sections of the Securities Act and Exchange Act. The court "stated that the Commission is entitled to injunctive relief and a temporary order of disgorgement of ill-gotten gains in the amount of at least $3.1 million." The court "held that imposition of any civil penalties would be determined after a criminal case against the defendants has been resolved."

On July 3, 2013, a final judgment was entered against Syndicated Food Service International, Inc that enjoins it from future violations of the Securities Act and Exchange Act. The SEC's original complaint "alleged that from 1997 through 2003" numerous defendants "participated in a massive broker bribery scheme involving the stock of nine public companies, including Syndicated." These defendants then sold the "stock into the public market for personal gain and paid undisclosed kickbacks to brokers responsible for selling the stock." The defendants that were previously charged include Nick Pirgousis, Frank Dolney, Gary Todd, Mario Casias, Thomas Tanis, Iain H.T. Brown, Fidra Holdings Ltd., William Brown, Joseph Ferragamo, and Christopher Quintana. Charges against Delta Asset Management Company, LLC, William Scott and Michelle Kramish Kain were dismissed.

According to the complaint (PDF), Kevin G. White and his companies, KGW Capital Management and Revelation Forex Fund, defrauded investors "in a foreign currency exchange trading scheme." According to the SEC, White raised over $7.1 million by "touting a sophisticated low-risk forex trading strategy yielding astronomical returns." He also claimed to have a 25-year Wall Street career. In reality, "the forex trading has incurred losses of investor funds, and White actually spent only six years as a licensed securities professional in Houston before being barred by the New York Stock Exchange two decades ago." White allegedly used more than $1.7 million of the investor money to cover his personal expenses. The court has "granted the SEC's request for an asset freeze and temporary restraining order against White, KGW Capital, Revelation Forex, and RFF GP LLC, which is the general partner of Revelation Forex." The SEC has charged the defendants with violationing sections of the Securities Act and Exchange Act and seeks "disgorgement of ill-gotten gains with prejudgment interest and financial penalties as well as preliminary and permanent injunctions."

Thursday, July 18, 2013

S&P Dow Jones Indices has recently updated their semiannual Persistence Scorecard, which studies the consistency of returns for actively managed US equity mutual funds. Like the previous Persistence Scorecard from December 2012, the updated study finds little evidence that actively-managed mutual funds can outperform stated benchmarks on a consistent basis.

In fact, the results are rather worse than in the previous study. The report highlights three factors:

Percentage of funds in top quartile two years ago which are still in top quartile:

These results once again suggest that, at least for US-based equity mutual funds, actively-managed funds rarely outperform for long. As pointed out in the comments section of our previous post, this does conflict with older studies of mutual fund performance persistence, but these most recent results from S&P Dow Jones Indices suggest that the probability of persistent outperformance is below the probability of a successfully guessing the outcome of a coin toss.

An interesting extension of this work could be a similar study of actively managed ETFs, as this space has been growing recently, but most funds would not have at least two years of performance results. We'll put that on our 2015 to-do list.

Investors should realize that such persistent outsized returns are extremely unlikely. Indeed, bank and brokerage records reveal that the Revelation Forex Fund did not begin trading until September 2011 and since that time has realized nearly $2 million in realized and unrealized losses through May 31, 2013 according to the SEC complaint (PDF). In addition to these investment losses, White has allegedly misappropriated approximately $1.7 million of investor funds for personal use or for unrelated business ventures.

White also misrepresented his education as well as a "25 year Wall Street career." White's career included only six years in the 1980's before being barred from the NYSE for conducting unauthorized trades in customer accounts and distributing misleading statements to customers and regulators, etc. Investors would have known this had they checked FINRA's BrokerCheck report on Mr. White (CRD# 1020670).

Investors who took the bait on other "opportunities" associated with KGW Capital (State of Texas Real Estate Fund, Meridian Propane Fund, KGW Energy Notes and KGW Tax-Free Certificates of Deposit) should probably begin taking a hard look at these investments since they are not registered with the SEC, the CFTC or FINRA. Investors should ask the tough questions when being faced with purported financial gurus who promise to deliver fortune with relatively few details.
_____________________________1 The CFTC is pursuing parallel criminal charges.2 The SEC has warned investors before (PDF) about the risks of forex trading.

Tuesday, July 16, 2013

Financial innovation is typically associated with banks, but lately we've seen a number of new financial products developed and sold by insurance companies. Some of the most interesting products are known as insurance-linked securities, or ILS.

In the broadest sense, ILS transfer risk from insurance companies to investors. The largest segment of the ILS market is in catastrophe bonds (or 'cat bonds' for short), whose interest and principal payments depend on a specifically defined natural disaster or other major insurable event not happening. Insurance companies issue ILS in order to sell risk to investors when traditional reinsurance companies are unwilling or unable to accept that risk at acceptable prices.

According to Swiss Re (PDF), ILS came about in response to Hurricane Andrew in 1992. The extreme damage caused by that storm left insurance companies, and the reinsurance companies that back them, with extensive losses and reduced reserves for further catastrophic events. The 2005 hurricane season, which included hurricane Katrina among others, also encouraged insurance companies to divest their risk exposure to capital markets. Effectively, the risks of insuring against disasters became so large that insurance companies began selling that risk to institutional investors, such as hedge funds, other insurers, and pension funds.

The market for ILS has grown significantly over time, according to a recent report (PDF) from Swiss Re, and new issuance is approaching the pre-crisis high.

However, there may be an adverse selection problem when insurance companies sell risk to outside investors. If insurance and reinsurance companies are the best firms for understanding and predicting losses, then they will only sell risk exposure when the market underprices it -- i.e., when the insurance company expects to profit from the sale. Pension funds, perhaps under pressure to deliver better than market rates of return, might underestimate these risks and thereby expose their investors to catastrophe-related insurance losses.

How large those losses might be can be difficult to determine even months or a year after an event (see the discussion of Hurricane Sandy in the Swiss Re report). ILS use complex criteria to determine whether a disaster or other event qualifies for coverage, and each ILS covers only specific types of events and particular geographic areas in which the disaster must occur. How transparent those criteria are can vary from one ILS to another ILS and are not standardized across the industry. Some ILS may also expose investors to a broader range of insurance-related losses, including operational risks of particular insurance companies.

ILS are a relatively new financial product and will likely evolve over time. But in current form, institutional investors may be exposed to the risk of a major catastrophe -- even if that catastrophe happens in a different state or country.

Monday, July 15, 2013

Investors in Residential Mortgage Backed Securities (RMBS) have suffered tremendous losses since 2007. Many junior and mezzanine investors were wiped out by the asset pools’ delinquency rates coupled with the subordination embedded in these structured securities. Since then, there has been a proliferation of litigation alleging that the underwriters and originators of RMBS misrepresented the risks of these products. An interesting new paper by Professors Piskorski and Witkin of Columbia Business School and Professor Seru of the University of Chicago, take a close look at misrepresentations in a dataset of 1.9 million loans originated from 2005 to 2007. Their research merges loan-level data on privately securitized mortgages (non-agency RMBS) and borrower-level credit report data and find that “buyers [of non-Agency RMBS] received false information about the true quality of assets in contractual disclosure by intermediaries during the sale of mortgages.”

The paper concentrates on two types of misrepresentations: 1) whether a loan reports the occupancy status of the borrower correctly--whether the home is used as a primary residence--and 2) whether a loan reports to have no simultaneous second liens when it does in fact have a second lien. The authors find that about 9% of all loans examined include one or both misrepresentations. The authors also find that the fraction of loans misrepresented was larger in states with higher pre-crisis growth in home prices, such as Arizona, Florida, California, and Nevada.

Fractions of Loans Reported As Owner-Occupied that Misreport Occupancy Status

Source: Piskorski, Seru, and Witkin (2013)

The authors also find that misrepresentation of collateral along these two dimensions significantly increases the risk of default. What’s even more interesting is that their paper finds evidence that the higher default risk of misrepresented loans was, at least in part, priced into the loans by the lenders. Loans with misrepresentations were charged a higher interest rate, suggesting that lenders were aware of these loans’ higher risks.

Although it seems like lenders incorporated knowledge of the true quality of the loans into their pricing by charging a higher interest rate on loans with misrepresentations compared to otherwise similar loans, the authors find no evidence that knowledge of the misrepresentations was reflected in the prices RMBS investors paid for the securities. They examine the average yield spread to Treasury securities and the level of subordination protection for the senior tranches in a sample of 353 mortgage pools finding “little evidence that misrepresentations were reflected in the initial prices of the RMBS securities.”

The paper documents some of the pitfalls of modern mortgage financing and securitization though clever use of exclusive datasets The packaging and reselling of mortgage pools allows the true quality of the assets in the pool to be misrepresented making it impossible for investors to assess their risks. The authors extrapolate to the pre-crisis $2 trillion non-agency RMBS market, and estimate that enforcement of the representations made to investors would lead to repurchases at par of about $160 billion (8% of the market) in loans by mortgage originators and underwriters. Given that their analysis only spans two criteria--owner occupancy and second liens on loans--their paper is likely to report a conservative lower bound for the prevalence of misrepresentations in non-agency RMBS loans.

Friday, July 12, 2013

This week Matthew J. Gagnon was sentenced to "five years of incarceration followed by three years of supervised release and ordered...to pay over $4.4 million in restitution to his victims." Gagnon had pleaded guilty to "one count of criminal securities fraud for promoting a securities offering without fully disclosing the amount of his compensation in connection with his promotion of the $72 million Legisi Ponzi scheme in 2006 and 2007." The criminal charges came from "the same facts that were the subject of a civil injunctive action that the Commission filed against Gagnon" in May of 2010.

Final judgments were entered against Martin C. Hartmann III and Laura Ann Tordy for their alleged involvement in Agape World, Inc., "an offering fraud and Ponzi scheme that raised $415 million" from investors. The final judgment permanently enjoins the defendants from violating sections of the Exchange Act and Securities Act and orders them to pay over $10 million combined in disgorgement, prejudgment interest, and penalties.

According to the complaint (PDF), unknown traders potentially used insider information regarding Onyx Pharmaceuticals, Inc.'s rejection of an acquisition offer from Amgen, Inc. to reap almost "$4.6 million in...profits." The SEC claims that the traders "took risky bets that Onyx’s stock price would increase by purchasing call options...three trading days before the announcement." An emergency court order was obtained by the SEC to freeze "the traders’ assets related to the Onyx call options transactions and [prohibit] the traders from destroying any evidence." The SEC has charged the traders with violating sections of the Exchange Act and seeks disgorgement, interest, financial penalties, and permanent enjoinments from future violations.

A final judgment was entered last week against Stewart A. Merkin, an attorney who allegedly "wrote letters falsely stating that his client, StratoComm Corporation, was not under investigation for violations of the securities laws." The SEC alleged that "Merkin knew that his statements were false because, at the time that he wrote each letter, he was representing StratoComm and several individuals in the Commission’s investigation into the company’s activities." Additionally, Merkin allegedly "authorized his letters to be posted on the website maintained by Pink Sheets LLC (currently OTC Markets Group Inc.) for viewing by the investing public." Merkin consented to the final judgment that orders him to pay $125,000 in disgorgement, prejudgment interest, and a civil penalty, and imposes a permanent injunction against future violations of the Exchange Act. Additionally, Merkin has been barred from "from participating in an offering of penny stock."

Canadian Court Enforces U.S. Judgment Award in Market Manipulation Case Against William Todd Peever and Phillip James Curtis, July 8, 2013, (Litigation Release No. 22745)

On June 20, 2013, "Canada granted summary judgment in favor of the Commission to recognize and enforce judgments previously entered in...New York against William Todd Peever and Phillip James Curtis, both of whom are Canadian citizens residing in British Columbia." The U.S. judgments hold "Peever and Curtis jointly and severally liable for $2,894,537.48 in disgorgement and $1,611,998.18 in prejudgment interest for their respective roles in a fraudulent scheme to manipulate the stock price of SHEP Technologies, Inc. f/k/a Inside Holdings Inc."

Last week an enforcement action was filed against John Fowler, "a convicted felon," as well as his son, "Jeffrey Fowler, a former Florida public school teacher, and Julianne Chalmers." According to the SEC, "from January 2011 through November 2011, John Fowler and Jeffrey Fowler raised approximately $4.3 million...through a Ponzi scheme disguised as a gold futures investment program." Chalmers allegedly acted as an unregistered broker-dealer and sold unregistered securities by soliciting "investors to invest in the gold futures program by purchasing promissory notes. "The enforcement action charges the defendants with violating various sections of the securities laws. John and Jeffrey Fowler have consented to the "entry of judgments, which would enjoin them from" future violations. "These judgments are subject to court approval. The SEC is seeking a permanent injunction, disgorgement, and financial penalties against Chalmers."

A parallel investigation was conducted by the U.S. Attorney's Office and resulted in felony convictions against John Fowler and Jeffrey Fowler.

Last week a criminal Information was filed against Jeffrey A. Liskov, which charged Liskov with "willfully violating Section 206 of the Investment Advisers Act of 1940." The SEC previously charged Liskov and his advisory firm, EagleEye Asset Management, LLC, with "defrauding advisory clients in connection with foreign currency exchange investments." The forex investments allegedly "resulted in client losses totaling nearly $4 million, while EagleEye and Liskov came away with over $300,000 in performance fees, in addition to other management fees they collected from clients." The SEC charged Liskov and EagleEye with violating sections of the securities laws and ordered them to pay over $1 million combined in disgorgement, prejudgment interest, and penalties.

Thursday, July 11, 2013

Yesterday evening, the Wall Street Journal reported that FINRA and several US exchanges fined the brokerage firm Newedge USA, LLC $9.5 million over alleged failures to adequately restrict automated client trading activity that "sought to manipulate U.S. markets for nearly four years." The trading activity took place on several exchanges including NYSE Euronext, NASDAQ OMX, and BATS Global Markets according to the WSJ article. FINRA's press release can be found here.

Newedge allegedly failed to prevent such manipulative tactics as "spoofing", "wash trades", and "marking the close". "Wash trades" increase the trading volume of a security without the security ever actually changing hands -- that is, the buyer and the seller are, for all intents and purposes, the same. "Marking the close" refers to behavior that attempts to manipulate the closing price of a security. This could be profitable if, for example, performance measures are calculated based upon the closing price.

Beyond these illicit trading activities, the regulators alleged that Newedge allowed customers to circumvent short-selling rules. According to the Wall Street Journal, "Newedge allowed some clients to operate through "by-pass" accounts, which enabled skirting of rules requiring firms to locate stock [...] before entering a short sale."

Newedge is no stranger to regulatory actions. According to FINRA's brokercheck, the firm currently has 47 regulatory event disclosures and one arbitration disclosure (though this even was more than a decade ago). We'll likely see more fines of this type as regulators crack down on trading strategies that attempt to manipulate the market.

However, the SEC may have no choice. Lifting the ban was required by the 2012 JOBS Act, and the SEC is already past the scheduled deadline to implement this and other provisions. According to the WSJ, the SEC will propose additional safeguards today (e.g. restrictions on sales materials, barring of "bad actors" or felons), but is moving forward with lifting the ban itself.

The hedge fund industry and some businesses have argued (and effectively lobbied to Congress) that the advertising ban limits their ability to raise capital. The JOBS Act was designed to encourage private investment in small companies, and thus lifting the ban was argued to promote private investment and thus stimulate job growth.

However, the proposal is rife with opportunities for fraud. Private placements often have very little transparency and include almost no regulatory oversight. Investors in private placements often have little access to their funds and are frequently given stale or managed information by sponsors. It will be very difficult to ascertain whether the claims made in general solicitations are accurate or supported by reasonable evidence, and many investors may find themselves drawn into misleading investments or outright scams.

That said, Congress may prove amenable to the SEC restricting general solicitation in some fashion for the sake of investor protections. It will be interesting to see the details of how the SEC intends to move forward with this controversial regulatory change.

Recently, the SEC has required structured product issuers to disclose an estimate of the intrinsic value of their notes. Bloomberg's Keven Dugan in the June 20 Structured Notes Brief collected 896 products and found that, according to issuers, the average instrinsic value in US structured notes ranges between 92-98% of face-value depending on product type. Longer term notes and range accruals tended to have the lowest estimated initial values.

Kevin analyzed how much of the discount (face-value minus initial value) is due to stated expenses. He came up with the following figure.

Importantly, the blue section and the red section don't level off at 100 cents on the dollar. This means that stated expenses are one reason that structured products are expensive, but not the whole story. Additional profit is priced into the notes, resulting in further mispricing.

In addition, he compared the reported values of four products to those produced by Bloomberg's own valuation service, BVAL. For those four products, there were pricing discrepancies of 0.7%, 1.2%, 1.7%, and 2.4%, suggesting that issuers may be using non-standard techniques for arriving at their product values.

The European Securities and Markets Authority (ESMA) recently conducted an empirical study of structured product pricing (PDF) in the European market. ESMA looked at a sample of 76 products issued in 13 countries. They find that the average structured product premium in the European market is approximately 5.5%.

These studies, combined with the growing body of academic work on structured products (including our own), strongly suggest that structured products have large upfront costs embedded in their derivative positions -- often beyond the stated fees.

Monday, July 8, 2013

Thomson Reuters will no longer be offering investors an early look at the results of the University of Michigan consumer-confidence survey, the NY Times reported yesterday and the Wall Street Journal is reporting this morning. The move was prompted by an investigation by the NY Attorney General and would likely be temporary while the investigation is ongoing.

We talked about this story a bit last week, emphasizing the in depth analysis conducted by Nanex, LLC on high frequency trading data following the early release of consumer-confidence data. Nanex has demonstrated that even a few seconds' worth of lead time can be enough for high frequency traders to significantly affect major financial markets.

A part of the story we haven't really touched on is the economics of buying and releasing the data. According to the NY Times, Thomson Reuters pays more than a million dollars annually to the University of Michigan for the exclusive rights to distribute the data early. About a dozen high-frequency trading firms pay somewhere around $6,000 a month for the privilege of receiving the data at 9:54:58 AM -- a full two seconds before other Reuters clients at 9:55 AM. This means that a significant portion of the costs to obtain this data is covered by the revenue generated from the high-frequency trading firms wanting that crucial two second advantage.

Nanex's work suggests that markets may move in response to the consumer confidence information before even Thomson Reuters' clients can to react at 9:55 AM. By the time the rest of the world receives this information at 10:00 AM, a great deal of price discovery has likely already occurred. It is no wonder that high frequency trading firms pay a premium for a mere two second advantage.

The regulation of high-frequency trading is something that will affect each and every investor since "more than half of all American stock trades are now executed by firms that rely on computer algorithms to execute thousands of orders a second." We'll continue to follow this story as it develops.

Friday, July 5, 2013

According to the complaint (PDF), eight Argentine citizens "unlawfully sold millions of shares" of Biozoom, Inc. (formerly Entertainment Art, Inc.) "in unregistered transactions" while two other Argentine citizens, Fernando Loureyro and Mariano Graciarena, also had received shares of Biozoom "but had not yet sold them." According to the SEC, from March to June 2013, the ten defendants received more than 20 million shares of Entertainment Art, which was one-third of the company's total outstanding shares." Eight of the defendants -- Magdalena Tavella, Andres Horacio Ficicchia, Gonzalo Garcia Blaya, Lucia Mariana Hernando, Cecilia De Lorenzo, Adriana Rosa Bagattin, Daniela Patricia Goldman, and Mariano Pablo Ferrari -- then sold over 14 million shares in a "one-month period." They gained almost $34 million from these sales and then wired almost $17 million to overseas bank accounts. The defendants claimed they received the shares from Entertainment Art shareholders "who purchased them in private placements that began in 2007" and provided " stock purchase agreements between them and the former shareholders purportedly signed by the defendants and those shareholders." The SEC alleges that "the documents were false because the Entertainment Art investors had sold all of their stock in the company in 2009, almost four years earlier."

The SEC seeks preliminary and permanent injunctions against the defedants, as well as the return of the "allegedly ill-gotten sale proceeds, and civil penalties."

Subramanian Krishnan, former CFO of Digi International, Inc., has agreed to settle SEC charges alleging that "he engaged in conduct which resulted in the filing of inaccurate reports and accompanying certifications in Digi’s annual quarterly reports from March 2005 through May 2010." The SEC alleges that Krishnan's conduct "resulted in corporate funds being used to pay for unauthorized travel and entertainment expenses." Furthermore, Krishnan allegedly "authorized such expenses for Digi employees, caused the Company to file inaccurate reports, failed to enforce Digi’s internal controls, demonstrated a lack of management integrity, and wrongly certified that Digi’s internal controls were effective." To settle the charges, Krishnan has consented to a final judgment that permanently enjoins him from future violations of the Securities Act and Exchange Act, imposes a five year officer and director bar against him, orders him to pay a $60,000 civil penalty, and suspends him "from appearing or practicing as an accountant before the Commission with the right to apply for reinstatement after five years."

According to the complaint (PDF), from 2006 through August 2010, Armand R. Franquelin and Martin A. Pool engaged in a Ponzi scheme and acted as unregistered broker-dealers by offering and selling more than $12 million in The Elva Group, LLC securities. The defendants allegedly encouraged investors to "convert funds held in [IRAs] into self-directed IRAs through Destiny Funding, LLC, another company owned by Franquelin and Pool, before investing those funds with Elva Group." Franquelin and Pool allegedly guaranteed "returns ranging from 10% to 240% per year." Franquelin and Pool then allegedly "misappropriated investor money for their personal use, to make 'interest' payments to earlier investors, and to pay for continuing Elva Group expenses."

The SEC has charged the defendants with violating sections of the Securities Act and Exchange Act and "seeks a permanent injunction as well as disgorgement, prejudgment interest and a civil penalty" from them. Additionally, "the complaint also seeks disgorgement and prejudgment interest from Judith Franquelin," Franquelin's wife, who was named as a relief defendant.

Pool consented to the entry of a final judgment that permanently enjoins him from future violations of the securities laws and orders him to pay over $1.3 million in disgorgement and prejudgment interest. However, "payment of disgorgement and prejudgment interest will be waived and no civil penalty will be imposed based on Pool’s current financial condition."

SEC Files Fraud Charges Against Fuqi International, Inc. and its Chairman and Former CEO and President Yu Kwai Chong, July 1, 2013, (Litigation Release No. 22739)

According to the complaint
(PDF), Fuqi International, Inc. and its Chairman of the Board of Directors and former CEO and President, Yu Kwai Chong "failed to disclose cash transfers of approximately $134 million to three purportedly unknown entities." According to the SEC, Fuqi's "full board of directors was not aware of and did not approve the cash transfers, and the transactions were made without any written agreement or repayment terms." The SEC claims that "Fuqi lacked adequate internal accounting controls and incorrectly recorded the cash transfers in its books and records as increases or decreases in 'other payables' or 'prepaids' accounts." Additionally, Chong allegedly "falsely certified" that one of Fuqi's quarterly reports "contained no material misstatements or omissions even though Fuqi, at Chong's direction, had transferred $27.6 million to unknown third parties during that quarter."

Fuqi and Chong consented to a final judgment that enjoins them from future violations of the securities laws, orders them to pay $1,150,000 combined in civil penalties, and bars ") bars Chong from serving as an officer and director for five years." An order has also been entered that revokes "the registration of each class of registered securities of Fuqi for failure to make required periodic filings with the Commission."

According to the complaint
(PDF), Mack D. Murrell, a former officer of The Dow Chemical Company, David A. Teekell (Murrel's long-time friend) and Charles W. Adams (Teekell's broker at Raymond James Financial Services, Inc) engaged in insider trading "that generated more than $1 million in illicit profits based on confidential information" concerning Dow's acquisition of Rohm & Haas Co. Murrell allegedly learned of the acquisition from his "then live-in girlfriend, now wife, who was the administrative assistant to Dow's Chief Financial Officer at the time." After learning this information, Murrell tipped Teekell who in turn tipped Adams. The complaint has also named Raymond James as a relief defendant.

The SEC seeks a final judgment that orders "disgorgement of ill-gotten gains together with prejudgment interest from the defendants and the relief defendant, and permanent injunctions and penalties against the defendants." Teekell has agreed to a final judgment that permanently enjoins him from future violations of the securities laws, as well as orders him to pay approximately $1.1 million in disgorgement, prejudgment interest, and a civil penalty.

According to the complaint
(PDF), Bret L. Boteler conducted "a fraudulent oil and gas-related securities offering" through his now-defunct company, EnerMax, Inc. "that raised more than $17 million from...investors." Boteler allegedly "falsely portrayed EnerMax to investors as an innovative, technologically sophisticated company offering high quality oil and gas prospects" and he "misrepresented and omitted material information about the speculative and unproven nature of the prospects in which EnerMax was involved." Additionally, Boteler allegedly "misused and misappropriated investor funds." The SEC has charged Boteler with violating sections of the Securities Act and Exchange Act and seeks civil penalties, disgorgement, prejudgment interest, and permanent injunctions against him.

According to the complaint (PDF), Matthew Madison, Dwight McGhee, and their company Infinity Exploration, LLC, "raised over $2 million from at least 40 investors from the fraudulent offer and sale of interests in Infinity's two oil and gas joint ventures." Infinity's offering materials allegedly misled investors "into believing that Infinity's ventures would own the leases and control drilling operations" when in fact "Infinity's ventures did not actually have direct interests in any oil and gas leases and no direct involvement in operation of any leases." Furthermore, the SEC alleges that "the defendants' offering materials falsely described Madison as experienced and successful in the oil and gas industry and failed to disclose McGhee's 2007 federal felony conviction." The SEC has charged the defendants with violating sections of the Securities Act and Exchange Act and seeks permanent injunctions, disgorgement, prejudgment interest, and civil penalties against the defendants.

Wednesday, July 3, 2013

The Maryland Public Policy Institute and the Maryland Tax Education Foundation released a report that uses data on state pension funds to question the value of active money management. The report finds that paying Wall Street managers to actively select and trade securities in state pension funds does not generate better investment returns, although it does provide higher fees and commissions for Wall Street managers. The results are in line with that of the S&P Indices Versus Active Funds (SPIVA) Scorecard that we covered earlier this year that found that most active managers underperformed their benchmark indexes during 2012.

The Figure shows the five-year annualized rate of return and the investment expenses as a fraction of net assets for 35 states with a fiscal year-end of June 30. Focusing on this set of states allows the comparison of the annualized rate of return for the same time period. Each dot on the Figure represents a different state and the solid line on the Figure is the trendline. The trendline’s slightly negative slope shows that higher investment expenses are typically accompanied by slightly lower rates of return on investment.

According to the report’s public data files, South Carolina was the state with highest investment expense with annual fees that equaled 1.31% of beginning-of-year net assets. The median investment expense of all 46 states reviewed was 0.39%. The authors state that indexing fees would equal about 0.03% annually and thus conclude that by indexing most of their portfolios, “the 46 state funds surveyed could save $6 billion in fees annually, while obtaining similar (or better) returns to those of active managers.”

The Maryland think tank argues that state pension funds should consider passive indexing. Such a switch from active management to passive management would be in line with current investment trends. Although active management funds still represent about 72% of the market, they made up 86% of the market a decade ago according to this article. In fact, the California Public Employees’ Retirement System, with $1.64 billion in defined-contributions plans, has recently voted to replace all actively managed funds with passive options citing cost savings as the main reason for their switch. It remains to be seen whether other states will follow suit.

Tuesday, July 2, 2013

You've heard it herebefore: hedging equity exposure with volatility derivatives is very tricky.

While the CBOE Volatility Index (VIX) and the S&P 500 are negatively correlated suggesting a possible hedging opportunity, you cannot invest in the VIX itself, you have to invest in derivatives (futures or options) linked to the VIX. The simple fact is that this indirect exposure to the VIX does not behave like the VIX itself (PDF), making it in the end a rather poor hedge to equities (PDF).

But issuers of exchange traded funds (ETFs) continue to develop ever more complex products that attempt to do just that. Several recent funds use highly sophisticated strategies to mitigate the severe losses that come from derivatives-based volatility exposure; the trick is to remove those effects without losing the negative correlation to equities that could make it valuable as a hedge.

On Monday, VelocityShares introduced the Volatility Hedged Large Cap ETF (SPXH) and the Tail Risk Hedged Large Cap ETF (TRSK). Both ETFs target an 85% allocation to the Vanguard S&P 500 ETF (VOO), iShares CORE S&P 500 ETF (IVV), and SPDR Trust Series 1 (SPY). But each also includes a 15% short position in a customized volatility swap. You can find a more detailed description of the two ETFs here (PDF).

Essentially SPXH and TRSK use a 2x leveraged volatility ETF (such as UVXY) and an -1x inverse volatility ETF (such as SVXY) in combination. They do so in different proportions. SPXH targets a net 35% long volatility position (roughly equal amounts 2x leveraged and -1x inverse exposure) and TRSK targets a net neutral position. The 2x leveraged position exhibits the compounding effects we have discussed before, which affects the overall volatility exposure. As VelocityShares describes it:

The returns of VIX futures themselves are combining with the mechanics of daily resetting exposures, to cause the volatility exposure to automatically and continuously adjust to the pattern of VIX futures returns, without relying on trading signals or market timing.

If that seems complicated, that's because it is. Here's how VelocityShares sums up the proposition:

Ultimately, investors need to determine the hedge that best meets their objectives by providing them with a high likelihood of hedging the magnitude of equity declines they are concerned about, and exhibiting a negative carry from VIX futures which is proportional to that hedge.

I don’t know what it is about volatility investing, but it seems to have
a special talent in producing products with dizzying complexity. In
the case of TRSK and [SPXH] we have two funds based on indexes that are
based on funds that are based on other indexes that are based on futures
that are occasionally synchronized with another index (CBOE VIX).

Couldn't be simpler.

It is not clear if these or other volatility-hedged equity ETFs will take off. There are concerns that the relatively high expense ratios of these products (0.71%) should only apply to the volatility component, since investors can obtain the equity component more cheaply by buying the underlying ETFs directly. In addition, there is some question as to whether such sophisticated strategies can be adequately explained to retail investors. But what is clear is that issuers are continuing to package ever more complex trading strategies in the ETF form.

Monday, July 1, 2013

Every month at 10:00 AM Eastern time, Thomson Reuters publishes the Institute for Supply Management (ISM) manufacturing data on its website. The ISM data is a widely cited benchmark, and its announcement can move stock markets. On June 3, that data was disappointing, and the stock market fell in response to the news. But it fell 15 milliseconds before the data was released.

Likewise, every month at 10:00 AM Eastern the University of Michigan publishes its Consumer Sentiment Index data through Thomson Reuters. Five minutes before, at 9:55 AM, Thompson Reuters announces that data to its paying subscribers on a conference call. But just two seconds before that, at 9:54 and 58 seconds, it sends that data to high frequency traders who pay a hefty additional fee for the service.

Clearly, there is an advantage to having potentially market-moving news before other traders. But how much could two seconds possibly be worth?

Potentially a lot. Nanex LLC, a high frequency data provider and analysis firm, has documented numerous examples of suspicious and potentially illegal high frequency trading activity. For example, you can find their analysis of the June 3 ISM manufacturing data announcement here, which was profiled by CNBC. They also found that trading in SPY, the largest S&P 500-linked exchange traded fund, topped 100,000 shares within ten milliseconds of the May 17 Consumer Sentiment Index early release, and that $40 million was traded within a half second.

The SEC is now investigating the relationship between ISM and Thomson Reuters, but clearly the problem extends beyond that single instance. As noted by the New York Times:

The incident speaks to the increasing importance of speed in the nation’s stock markets. More than half of all American stock trades are now executed by firms that rely on high-speed connections to place and withdraw thousands of orders a second. In order to compete, these traders look for any leg up, including quicker ways to receive market data.

It is not clear what tack the SEC, the exchanges, or other regulators might take in response to these trading strategies. But it is now becoming clear that they are prevalent and can have a significant market impact.

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